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US v. Newman and the Rewriting of the Law of Insider Trading (Part 4)

So what exactly did the Court hold? 

The majority in Dirks determined that insider trading occurred when an insider disclosed material non-public information in breach of a fiduciary duty. The Court, however, used the phrase without any reference to state law.  This was presumably intentional.  State law would not have supported the analysis.  This could be seen in a number of ways.

First, Dirks involved a tip by an officer (or former officer).  Under state law, officers had a fiduciary relationship that ran to shareholders.  Limiting insider trading to fiduciaries, however, left out more than it included. 

Corporate advisers such as accountants and lawyers were not typically fiduciaries.  Nor were the persons inside the company delivering the mail or moving boxes at the loading dock.  Fiduciary duties extended to officers, directors, and key employees but not everyone working for the corporation.  Limiting insider trading to those with a traditional fiduciary obligation would, therefore, exclude large swathes of persons with access to material non-public information from the prohibitions imposed by Rule 10b-5. 

Even with respect to officers, problems existed.  Fiduciary duties ran to shareholders.  Yet insider trading often occurred when officers sold shares aware of impending negative developments.  Unless selling to existing shareholders, the insider had no fiduciary obligation to those purchasing the shares until after they became shareholders. 

Second, limiting insider trading to instances where the tipper had a fiduciary obligation did not fully accomplish the Court’s goal.  Under traditional state law concepts, a fiduciary could violate his or her duties when not acting in the best interests of shareholders.  This left officers interacting with market professionals open to claims that they improperly “tipped” information anytime they did so in a context that did not appear to benefit the corporation.  

The Court addressed some of these problems and left others unattended.  We will look at the analysis in the next post.  

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 3)

The Supreme Court confronted the facts in Dirks with a clear goal.  The majority intended to make certain that the law of insider trading did not unnecessarily impede communications between the company and market participants.  In doing so, the Court opted for an overbroad test that unquestionably sanctioned behavior that, in any common sense world, would constitute insider trading.  Better to let off some individuals who engaged in insider trading than to leave in place a test that chilled legitimate communications with market participants. 

The Court did so by using a vocabulary familiar to any corporate lawyer.  Insider trading was keyed to fiduciary duties and a breach of those duties.  Yet the Court then departed from conventional law by interpreting those terms in a manner largely unrecognizable to those practicing in the area.  In part as a result, the Court had to invent an approach and lexicon that filled gaps created by its own analysis.  We will explore this in a bit more detail in the next post.

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 2)

Lets start at the beginning, with Dirks.  

Dirks involved allegations that an insider (actually a former insider) tipped information to Dirks, an analyst.  The information related to possible fraud at an insurance company.  Dirks attempted to expose the fraud by going to media outlets (the WSJ) but to no avail.  Ultimately, he informed five investment advisers of the information.  The advisers liquidated their positions in the relevant company and ultimately avoided the rout that occurred in share prices once the fraud was exposed. 

It was not a very sympathetic set of facts for an insider trading claim against Dirks but the SEC brought it nonetheless (in the form of an administrative proceeding).   See In re Dirks, Exchange Act Release No. 17480 (admin proc Jan. 22, 1981) (“On the basis of the Commission's opinion issued this day, it is ORDERED that Raymond L. Dirks be, and he hereby is, censured.”).  The Commission’s opinion acknowledged the concern that the action would interfere with disclosure that was important to investors and actually reduced the sanction imposed by the administrative law judge.  As the Commission noted:  

  • We fully appreciate the importance of the analyst's work in providing public investors with an accurate and complete factual basis upon which to make their investment decisions. Accordingly, we do not seek in any way to chill the investigation of rumors concerning a particular company. Nonetheless, the analyst's role, like that of any other person, is constrained by the well-established proscriptions of the antifraud provisions of the federal securities laws, and we cannot condone the unfairness inherent in the selective dissemination of material, inside information prior to its public disclosure. Neither the analysis set forth above, nor the sanction we impose, should hamper legitimate, investigative securities analysis. 

21 S.E.C. Docket 1401 (1981).  For the SEC, however, it was enough to show that the tippee provided information from an insider knowing that the recipient would trade on the information.  Id.  (“Such a tippee breaches the fiduciary duty which he assumes from the insider when the tippee knowingly transmits the information to someone who will probably trade on the basis thereof.”). 

Light though the sanction was, the SEC nonetheless penalized an analyst who had tried to get the information to news outlets and ultimately contributed to the exposure of a major fraud.  Under the logic of the decision, future analysts in the same position would have an incentive to remain silent out of fear of liability, depriving the market of important information. 

Even broader, any analyst who received nonpublic information as a result of doing his or her job (meeting with management for example) would be open to claims of insider trading if taking advantage of the information.  Moreover, given the uncertainty of any materiality analysts, analysts receiving nonpublic information could rationally conclude that it was better not to use the information even if likely immaterial.  Thus, a standard that allowed insider trading claims to be brought whenever insiders “tipped” information that would then be used to make trading decisions had the potential to “chill” the flow of information to the market.  See SEC v. Dirks, 463 US 636 (1983) (“Imposing a duty to disclose or abstain solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market”).  

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 1)

In US v. Newman, a panel of the Second Circuit dismissed a conviction for insider trading against two defendants.  The Government has sought rehearing en banc and the Commission has filed an amicus brief supporting the efforts.  A small group of law professors (Professors Bainbridge, Macey and Henderson) have filed an amicus brief arguing that the decision is correct.  

The case is worthy of consideration for a number of reasons.  First, it reflects a substantial rewriting of the law of insider trading.  The decision essentially eliminated the gift analysis from Dirks and removed from the prohibition on insider trading tips of information to family and friends absent the presence of an exchange "that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature."  Given that many "tips" to friends and family will not be motivated by the potential for pecuniary gain, the court has essentially eliminated from the prohibition on insider trading the exchange of information by family members.   

Second, the panel in Newman consisted of three judges appointed by Republican presidents, two of them senior judges (Winter and Parker) and one active (Hall).  The en banc court, however, includes 13 full time judges, with eight appointed by Democratic presidents.  To the extent that the case goes en banc and is decided along party lines (based upon the political party of the appointing president), the decision will be reversed.      

Finally, the opinion is of interest because of other areas where the Second Circuit seems to be rewriting the law under Rule 10b-5.  In ParkCentral v. Porsche, for example, a panel of the Second Circuit essentially reinstated an “affects test” for determining the extraterritorial application of Rule 10b-5 in a manner that can only be used to deny, rather than grant, jurisdiction.   

In contending that the Second Circuit was incorrect (in both Newman and Porsche), the conclusion is based upon the law as it is.  Given, however, a desire by some on the Supreme Court to narrow the application of Rule 10b-5 (see Janus, Morrison and Stoneridge), the Second Circuit’s rewriting of the law may well be approved if it makes it to the Supreme Court.    

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  


Robert Bach, et al v. Amedisys: District Court’s Dismissal Reversed and Remanded

In Bach v. Amedisys Inc., No. 13-30580, 2014 BL 291495 (5th Cir. May 20, 2014), the United States Court of Appeals for the Fifth Circuit reversed and vacated the district court’s decision granting the defendant’s motion to dismiss and, accordingly, remanded the case for further proceedings.

Amedisys is a home health company and, as provided by federal law, receives Medicare reimbursement only when providing patients with medically necessary services. From 2005 – 2009, Medicare reimbursements accounted for approximately 90% of the company’s total reimbursements for services rendered.

The Public Employee’s Retirement System of Mississippi and Puerto Rico Teacher’s Retirement System (together, “Plaintiffs”) filed suit against Amedisys, Inc. (“Amedisys”) and seven prior and current board members (collectively, “Defendants) for violating sections 10(b) and 20(a) the Securities Exchange Act of 1934 alleging Defendants defrauded investors by concealing a Medicare fraud scheme.  Plaintiffs alleged that Amedisys engaged in fraud when it (1) pressured employees to perform unnecessary service visits in order to maximize Medicare reimbursements, and (2) released materially false or misleading statements causing Amedisys’s stock to be traded at an inflated price. Plaintiffs further alleged that when information regarding potential fraud became publicly available, Amedisys’ stock values dropped, causing significant financial loss to shareholders.  The district court dismissed the claim, finding that plaintiffs had not sufficiently alleged loss causation. 

To bring an action under Section 10(b) and Rule 10b-5, plaintiff must allege that the  “misrepresentations (or omissions) proximately caused Plaintiff’s economic loss.” To demonstrate proximate cause, a plaintiff must allege that when a “relevant truth” regarding fraud became public, it caused stock prices to fall, thereby proximately causing the economic harm. The court emphasized the “test for ‘relevant truth’ simply means the truth disclosed must make the existence of actionable fraud more probable than it would be without that alleged fact, taken as true.”

In applying the standard, the court found that plaintiffs had sufficiently alleged the requisite causation. 

  • The Complaint consists of over 200 pages of allegations regarding, among other things, Defendants’ fraudulent Medicare billing practices. Where the Complaint sets forth specific allegations of a series of partial corrective disclosures, joined with the subsequent fall in Amedisys stock value, and in the absence of any other contravening negative event, the plaintiffs have complied with Dura’s analysis of loss causation. 

In so holding, the court asserted that it was evident “the whole is greater than the sum of its parts.”

Accordingly, the United States Court of Appeals for the Fifth Circuit reversed and vacated the district court’s decision granting Defendant’s motion to dismiss, and remanded the case for further proceedings.

The primary material for this case may be found on the DU Corporate Governance website.


Special Projects Segment: Comment Letters in Favor of the Proposed Crowdfunding Rules

We are discussing possible Rulemaking Regarding Crowdfunding under the JOBS Act.

On October 23, 2013, the Securities and Exchange Commission (“SEC”) issued its proposed Crowdfunding rules (“Proposed Rules”) in response to Title III of the Jumpstart Our Business Startups Act of 2012 (“JOBS Act”). The rules are designed to permit general solicitations to non-accredited investors through brokers or over crowdfunding platforms. The rules seek to protect investors against fraudulent offerings while facilitating capital raising. The public comment period closed on February 3, 2014, and the SEC has not issued final rules. 

The SEC received over 500 public comment letters. Some remarks supported the Proposed Rules. Many, however, expressed concern the regulations would stifle startup companies.

The Rules would require audited financial statements for issuers offering more than $500,000 in securities through a crowdfunding offering.  Moreover, the new rules state that financial statements must be reviewed by a Certified Public Accountant (“CPA”) for offerings between $100,000 and $500,000.  CPAs generally endorsed the mandatory reporting requirements imposed on companies using the exemption.

Many CPAs, however, echoed the reservations expressed in Ernst & Young’s comment letter that urged the SEC to reconsider requiring startup companies to report two years of U.S. GAAP-based financials because the requirement was onerous and expensive. As an alternative, Ernst & Young recommended, and the American Institute of Certified Public Accountants (“AICPA”) mainly concurred, that startup companies should be permitted to report their financials by using an Other Comprehensive Basis of Accounting (“OCBOA”). The AICPA comment letter specifically noted the “crowdfunding provisions of the JOBS Act were designed to help make raising capital through securities offerings less costly for startups and small businesses” and asserted that the use of an OCBOA would help advance that goal.

The North American Securities Administrators Association, Inc. (“NASAA”) also submitted a comment letter, which noted the importance of a “balanced regulatory approach that minimizes unnecessary costs and burdens on small businesses while providing meaningful investor protection from fraud and abuse.” NASAA supported the efforts to protect investor privacy, grant investors the ability to cancel investment transactions, require job creation reporting, provide for transparent, independently audited financial statements, and bar bad-actors from crowdfunding. NASAA nevertheless warned the Proposed Rules created unnecessary statutory ambiguity. NASAA posited the JOBS Act clearly required funding from all sources to be limited to a $1 million ceiling. The SEC’s proposal, however, provided for a $1 million cap that looked only to other crowdfunding offerings during the prior 12 months. NASAA feared this interpretation could potentially allow for abuse by large companies and distort congressional intent.   

Comments in support of the Proposed Rules shared some commonality in their concerns. Ernst & Young, the AICPA, and NASAA urged the SEC to consider underlying congressional objectives. They stressed, as did many other commenters, that overregulation could make equity based crowdfunding too onerous and expensive for startup companies. They also warned this provision should be cautiously tailored to prevent abusive practices by larger companies.

Despite the importance of investor protections, many proponents of the new regulations feared that the costs of compliance with the Proposed Rules would outweigh the benefits.  As a result, small businesses and startups would be unable to use the exemption as a source of capital raising.


SEC v. Shavers: Over $40 Million Disgorged in Bitcoin Fraud Case

In SEC v. Shavers, No. 4:13-CV-416, (E.D. Tex. Sept. 18, 2014), the United States District Court for the Eastern District of Texas entered final judgment against Trendon T. Shavers and Bitcoin Savings and Trust (“BTCST”) and ordered them to pay more than $40 million in disgorged profits and prejudgment interest. The court further required each defendant to pay an additional civil penalty of $150,000. 

According to the SEC’s allegations, Shavers established BTCST, an unincorporated online entity, in February 2011, in order to obtain investments that would provide returns in the form of bitcoins. Shavers used online chat rooms to solicit BTCST investors with false promises of earning interest of up to 7% every week. According to the court, “[t]he uncontested summary judgment evidence establishes that Shavers knowingly and intentionally operated BTCST as a sham and a Ponzi scheme, repeatedly making misrepresentations to BTCST investors and potential investors concerning the use of their bitcoins; how he would generate the promised returns; and the safety of the investments.”   

The SEC alleged Shavers violated Section 10(b) of the Exchange Act and Rule 10b-5, as well as Section 17(a) of the Securities Act. Section 10(b) and Rule 10b-5 prohibit (1) the use of any “device, scheme, or artifice to defraud”; (2) “an untrue statement of a material fact” or omission; or (3) “any act, practice, or course of business which operates . . . as a fraud or deceit upon any person.” Additionally, to establish liability, the SEC had to prove Shavers acted with scienter or “an extreme departure of the standard of ordinary care . . . and a danger of misleading [investors] . . . so obvious the defendant must have been aware of it.” To establish Section 17(a) Security Act liability, the SEC had to prove the same elements, but without the scienter requirement. The SEC also alleged that Shavers violated Section 5 of the Securities Act of 1933 by failing to register the investments in BTCST. 

In pretrial motions, the court addressed whether the interests in BTCST were investment contracts under the federal securities law. Because investors paid for the interest in bitcoins, Shavers argued that bitcoins were not currency and the interests did not involve an investment of money. The SEC argued that the use of bitcoins constituted an investment of money. In an August 6, 2013 ruling, the court agreed and held that the investments in BTCST were in fact securities. 

In the September 2014 ruling, the court addressed the claims under Section 10(b) of the Exchange Act and Sections 5 and 17(a) of the 1933 Act.  As the court found:  

  • From February 2011 through August 2012, contrary to representations Shavers made to BTCST investors, the risk of the BTCST investments was not "very limited" or "almost 0"; Shavers did not receive "cash in hand" before moving any BTCST investors' bitcoins; and Shavers was not, as he promised investors, in a position to cover any losses personally.
  • From February 2011 through August 2012, contrary to representations Shavers made to BTCST investors, BTCST was a sham and a Ponzi scheme, whereby Shavers used new bitcoins received from BTCST investors to make payments on outstanding BTCST investments and diverted BTCST investors' bitcoins for his personal use.

It also found Shavers acted with “a high degree” of scienter. See Id. (“Shavers made blatant misrepresentations to BTCST investors concerning the use of their bitcoins and the safety of their investments, while running BTCST as a sham and a Ponzi scheme, and diverting BTCST investors' funds for his personal use, including rent, car-related expenses, utilities, retail purchases, visits to casinos, and meals. Defendants' conduct was not an isolated occurrence.”). 

The court also determined Shavers violated Sections 5(a) and 5(c) of the Securities Act. In order to violate Sections 5(a) and 5(c) a defendant must (1) offer or sell a security; (2) without filing a registration statement with the SEC; and (3) make use interstate communication in connection with the offer or sale. The court held the investments were previously determined to be a security, there was no evidence a BTCST registration statement had been filed. Id. (“Here, Defendants violated Sections 5(a) and 5(c) because there was no registration statement filed or in effect as to the BCTST securities offered and sold over the Internet.”). 

Accordingly, the court ordered disgorgement of over $38 million in profits, payment of prejudgment interest totaling $1.8 million, a civil penalty against each Defendant of $150,000, and permanently enjoined Shavers and BTCST from future violations of Sections 5 and 17(a) of the 1933  Act, as well as Section 10(b) of the Exchange Act and Rule 10b-5.

The primary materials for this case may be found on the DU Corporate Governance website.


Developments and Visions of the SEC for the Future

In alignment with the vision of Alan B. Levenson, co-founder of the Securities Regulation Institute, members of the “private bar and SEC staff” gathered together earlier this year in an effort to strengthen communications between the private and public players in the capital markets. SEC Chair Mary Jo White gave the keynote address, focusing her speech on the evolution of market technology, financial products, and the response to the SEC’s 2014 rulemaking initiatives. Moving forward, the SEC can be expected to maintain a similar agenda in these areas, as was discussed by White. A full transcript of the speech can be found here.

Over the course of its 80-year history, the SEC has maintained initiatives geared toward protecting investors, allowing companies of all sizes to raise funds, and ensuring the fair and efficient functioning of the markets. Constant technological advances, however, have forced the SEC to adapt to such technology and harness its accompanying benefits in order to further various objectives that remain in line with the SEC’s mission. The SEC utilizes these advances by creating new software and database systems. For example, the SEC developed the National Exam Analytics Tool (“NEAT”), an instrument that allows examiners to quickly and efficiently analyze huge amounts of transactional data. The NEAT system makes it easier for the SEC to monitor and, in turn, investigate suspicious behavior in the industry. Similarly, the new Market Information Data Analysis System (“MIDAS”) collects, records, and analyzes trading data ultimately helping the SEC and other regulatory bodies develop a better understanding of trending behaviors occurring in the market. The SEC has also emphasized the more effective utilization of existing technology to address vulnerabilities in market infrastructures. In the near future, this may include the adoption of Regulation SCI (Systems Compliance and Integrity), which would impose stricter requirements for the use of technology in the securities industry.

The financial products market is another area that has experienced huge changes in recent history and has been the subject of SEC reformation. First, the SEC has recommended, under the direction of the Dodd-Frank Act, creating greater transparency for security-based swaps and similar derivative transactions. Second, in response to concerns about the instability of money market funds, the SEC is considering two proposals formulated to work concurrently with amendments made in 2010 to “reduce interest rate, credit, and liquidity risks.” One such proposal would implement a “floating Net Asset Value (“NAV”) for prime institutional money market funds,” and the other would “impose a liquidity fee and permit . . . redemption gates.”  The SEC expects these reforms to be completed in 2014. Lastly, the SEC is looking to finalize new disclosure rules for asset-backed securities, spurred by the enactment of the Dodd-Frank Act.

These new ideas have inspired new ways of thinking amongst investors, regulators, and companies seeking investors. This has caused the SEC to “reconsider how companies can seek capital and communicate with potential investors.” Accordingly, the SEC has adopted rules to amend the requirements for general solicitation as part of a plan to implement the JOBS Act. Companies have been utilizing this new rule, with the amount of capital raised in private offerings surpassing that of public offerings in the last few years. Additional rules related to Crowdfunding and Regulation A have also been proposed by the SEC, and along with past developments, should allow for “companies of all sizes . . . to raise capital.” The SEC does not, however, intend for these new rules to change their goal of reforming disclosure requirements for public companies.

As a last area of focus for 2014, the SEC intends to continue its pursuit of vigorous enforcement.  The first step in addressing this goal is to allow the SEC to require “admissions of guilt [in settlements] where parallel criminal or other regulatory cases were brought with admissions.”  This change would force companies to have greater accountability for their actions, a goal also in line with the Financial Reporting and Audit Task Force.  Furthermore, the exchanges and alternative trading systems have been the target of recent SEC enforcement, with rules enacted to ensure that they are operated fairly and in accordance with applicable standards. 

Although these items are only part of the SEC’s agenda for the coming year, these examples indicate the potential issues the SEC may focus on in the upcoming months.  As Chairwoman White stated, “it is a constant, but always exciting, challenge to keep pace and indeed to accurately see around the next corner for the newest market developments or another innovative variant of, or new venue for, fraud.”  By keeping up with developments in market technology, financial products, and the vulnerabilities that they create in the market, the SEC boasts a plan that should help it remain true to its longstanding 3-prong mission.


Eastern District of Washington Reaffirms Strict Securities Fraud Pleading Requirements

In Roseville Employees Retirement System v. Sterling Financial. Corp., 2014 BL 257904 (E.D. Wash. Sept. 17, 2014), the United States District Court for the Eastern District of Washington dismissed a securities fraud complaint filed by the City of Roseville Employees' Retirement System (“Plaintiff”) against Sterling Financial Corporation, CEO Harold Gilkey, and CFO Daniel Byrne, (collectively, the “Defendants”). 

According to the complaint, Sterling Financial Corporation was a bank holding company with two subsidiaries, Sterling Savings Bank and Golf Savings Bank (collectively, “Sterling”). From 2008 to 2009, Sterling’s allowance for credit losses increased by $186.7 million, non-performing assets increased by $684 million, and Sterling’s non-performing construction loans increased by $441.8 million. 

In October, 2008, the Federal Deposit Insurance Corporation (“FDIC”) and the Washington Department of Financial Institutions (“WDFI”) found that Sterling improperly calculated losses on certain loans. The Board of Sterling received a “Report of Examination” that contained the findings.  In June 2009, the FDIC and WDFI “prepared a Notice of Charges, and issued a joint Report of Visitation.” According to the complaint, the Board “fired” the CEO and CFO four months later.     

The complaint alleged securities fraud on the theory that Sterling’s financial statements were inaccurate and the Defendants made “materially false and misleading” assurances between 2008 and 2009 describing Sterling as “maintaining safe, sound and secure banking practices.” 

The Private Securities Litigation Reform Act (“PSLRA”) “requires that the complaint plead with particularity both falsity and scienter.” Scienter is the intent to deceive and must be pled using specific facts that create a strong inference that the defendant made false statements “intentionally or with deliberate recklessness.” To the extent relying on a confidential witness, the complaint must establish the reliability and personal knowledge of statements “indicative of scienter.” Additionally, scienter based on violations of generally accepted accounting practices must show “the accounting practices were so deficient that the audit amounted to no audit at all.”

The court found that the complaint did not meet the PSLRA’s strict pleading standard required to show scienter. The statements from Sterling describing the bank as “safe and sound” were non-actionable “corporate puffery” because there was no reasonable standard against which to measure them. Plaintiff also did not adequately establish the reliability or personal knowledge of a confidential witness. And finally, the evidence offered in the complaint was not specific enough show how Sterling’s financial statements were inaccurate.

The court also noted that the defendants Gilkey and Byrne held stock in Sterling without selling during the entire period in question and no regulatory agency ever required Sterling to restate its financials.         

For the above reasons, the District Court for the Eastern District of Washington granted the Defendant’s motion to dismiss. 

The primary materials for this post are available on the DU Corporate Governance website.


SEC v. Narvett: Court Orders Disgorgement and Civil Penalties

In SEC v. Narvett, No. 13-C-927, 2014 BL 287642 (E.D. Wis. Oct. 14, 2014), the United States District Court for the Eastern District of Wisconsin held the proper amount the defendant must disgorge was the amount improperly obtained from investors less any documented amounts returned to investors.   Additionally, the court found that while Defendant's brother was willing to write off his contribution as a personal loan, the money was obtained fraudulently and must be included in the disgorgement calculation. The court also ordered civil penalties because Defendant's conduct was intentional and resulted in substantial losses. 

Defendant, the owner of Shield Management Group, Inc., agreed that he would not contest allegations brought by the Securities and Exchange Commission ("SEC") that he violated Section 17 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act in connection with a fraudulent scheme involving the offer and sale of promissory notes to family, friends, and others.  Therefore, the only issue left to the court was the amount of monetary relief owed.  The SEC sought relief in the form disgorgement of profits with interest, and a civil penalty.

The SEC sought disgorgement of $746,331.75, an amount they believed reflected the actual amount misappropriated. Defendant, however, contended the SEC failed to credit him the funds returned to investors and the personal loan of $50,000 from his brother.  The SEC, asserted that the repayments to investors were made in bad faith.  At least some of the funds came from $460,000 in personal loans obtained by the Defendant.  The loans, however, “were structured so as to avoid SEC jurisdiction and the lenders explicitly acknowledged that before making the loans they were aware" of Defendant's "'ongoing legal developments' with the SEC.”  The SEC also argued that the Defendant could only provide bank records to prove he returned $410,634 to investors. 

The court agreed that Defendant's loan from his brother was raised through the fraudulent scheme and as such, was subject to disgorgement; however, it also found that the penalty should be reduced by the amount returned to investors. The court based its calculation on two principles. First, because the burden of proof falls to the defendant regarding disgorgement, the court found the Defendant should be credited only for payments with proper supporting documentation. 

Second, the court required the SEC to distinguish between legally and illegally obtained profits because disgorgement may not be punitive. Because the proper disgorgement amount is the total contribution from investors less the distributions made, the court found that the Defendant reduced the amount of his gain by substituting personal debt for some of the profits and, thus, reduced the disgorgement amount. Based on this reduction, the court found the appropriate disgorgement was $335,697.42. Using a pre-judgment interest rate supplied by the Internal Revenue Service, the interest was determined to be $18,886.50.

The court next addressed the issue of civil penalties. Sections 20(d)(2) and 21(d)(3)(B) set forth three tiers of monetary penalties for violations, under which the maximum penalty is the greater of either “the gross amount of pecuniary gain” resulting from the violation or a statutory amount. The Defendant's fraud raised more than $746,000, exceeding the statutory cap under all three tiers and setting the maximum penalty at $746,000.

The court imposed a significant civil penalty of $300,000. In explaining the significance, the court reasoned:

  • In this case, significant penalties are in order. [Defendant's] conduct was intentional. He has not admitted wrongdoing, and he has never explained his actions. Although the actual amount of losses incurred by the victims of [Defendant's] fraud remains to be seen, there is no question that his conduct created very substantial losses. Further, as noted by the SEC, the conduct at issue was not isolated, but involved recurrent Ponzi-like payments to investors while [Defendant] misappropriated investors' funds for personal use. Finally, with respect to [Defendant's] contention that he is broke, the fact that he may be destitute is not necessarily reason to reduce the penalty. The SEC interprets the fact that [Defendant] is destitute as proof that [Defendant's] paying back investors by soliciting loans was not in good faith, and that he is a continuing threat to the public. Given the ongoing dishonest and egregious breach of trust displayed by [Defendant] and the substantial amounts of money he obtained, I find that [Defendant's] financial difficulties are not a strong reason to reduce the civil penalty.

In sum, the United States District Court for the Eastern District of Wisconsin ordered the [Defendant] to disgorge profits of $335,697.42 with a prejudgment interest of $18,886.50 and pay a civil penalty of $300,000.

The primary materials for this post can be found on the DU Corporate Governance website.


Board Sued for Failure to Monitor Finances in Weiss v. E-Scrub Sys., Inc.

In Weiss v. E-Scrub Sys., Inc., C.A. No. 13-710-GMS., 2014 BL 260961 (D. Del. Sept. 19, 2014), Stanley Weiss, a New Jersey citizen brought a derivative suit on behalf e-Scrub, a Delaware Corporation against four persons alleged to have been directors, Ralph Genuario, Maija Harkonen, John Packard, and Elizabeth Richardson as defendants. Two of the defendants, Richardson and Packard, moved to dismiss. 

The complaint alleged that the defendants breached their fiduciary duties due to the board’s failure to mitigate e-Scrub’s financial problems. Weiss asserted that the defendants violated their duties of good faith and loyalty by not using an adequate reporting system to manage e-Scrub’s finances. Weiss maintained that defendants knew of e-Scrub’s financial problems as of 2007, but failed to investigate. 

With respect to the right to maintain derivative suits, creditors replace shareholders after a corporation becomes insolvent and have the right to any residual value.  Consequently, creditors may have standing to bring this type of action. Standing, however, requires that creditors have that status at the time of the alleged breach of duty regardless of when it was noticed.  Furthermore, in order to prove a corporation’s insolvency, a plaintiff is required to allege facts that, if accurate, would make evident the fact that the corporation was insolvent. 

Weiss’s evidence of insolvency rested primarily on a statement by one of the defendants that the “stock was worthless”.  The United States District Court for the District of Delaware held this to be insufficient evidence of e-Scrub’s insolvency. Id. (“This statement is insufficient to show e-Scrub was bankrupt or had such insufficient assets that the business could not reasonably continue and succeed.”).  In addition, the court found that plaintiff had become a creditor “following the alleged wrongdoing”.  As a result, the court granted Packard’s and Richardson’s motion to dismiss. 

The primary materials for this case can be found on the DU Corporate Governance website.


SEC v. Quan: Final Judgment Entered and Remedies Granted in Securities Fraud Action

In SEC v. Quan, No. 11 Civ. 723 ADM/JSM, 2014 WL 4670923 (D. Minn. Sept. 19, 2014), the United States District Court of Minnesota denied motions for judgment as a matter of law and a new trial made by Marlon Quan (“Quan”) and three entities owned and controlled by Quan (collectively the “Defendants”), and partially granted the Securities and Exchange Commission’s (“SEC”), motion for remedies and final judgment on Quan’s liability for securities fraud. The court also granted the SEC’s motion for injunctive relief, disgorgement, and prejudgment interest, but denied the request for civil penalties.

According to the allegations of the SEC, Quan, operated two hedge funds, Stewardship Credit Arbitrage Fund LLC (“SCAF LLC”) and Stewardship Credit Arbitrage Fund, Ltd. (“SCAF Ltd.”) (collectively, the “SCAF Funds”). The marketing materials described risk management techniques designed to protect SCAF funds that the SEC claimed were “never implemented.”  The SCAF Funds’ invested a considerable amount of funds in PAC Funding LLC, which was later revealed to be a Ponzi scheme.

The SEC filed suit against Quan alleging he misled investors, violating Section 17(a) of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Exchange Act of 1934. On February 11, 2014, a jury found Defendants liable for securities fraud. Defendants moved for judgment as a matter of law and a new trial.

Defendants first argued that the verdict was inconsistent given the jury found Defendants liable under Section 10(b), but not under Section 17(a)(1), a substantially identical provision. To prove a violation of those sections, Plaintiff must establish Defendants “(1) engaged in prohibited conduct (i.e., employed a fraudulent scheme, made a material misstatement or omission, or engaged in a fraudulent business practice); (2) in connection with the offer, sale, or purchase of a security; (3) by means of interstate commerce.” The court held, however, the verdicts could be harmonized because the jury could have found Defendants did not initiate the fraudulent scheme, but did make material misrepresentations and engage in fraudulent practices. Thus, the jury’s finding that Defendants were liable under Section 10(b) but not 17(a)(1) would not be so inconsistent as to require a new trial.

Second, Defendants argued the instruction to the jury was erroneous because they did not require unanimous agreement on which specific misstatement was in violation. The court, however, determined juror unanimity was not required for material misrepresentations and omissions.  “Courts interpreting federal fraud statutes traditionally do not require a jury to unanimously agree on the particular acts a defendant used to commit the fraud.”

Finally, the court examined Defendants’ argument that the verdict finding Defendants acted with scienter was against the greater weight of evidence. Scienter could be inferred if there was “strong circumstantial evidence of conscious misbehavior or recklessness…” The court found that the standard was met through the testimony of several witnesses’ testimony and in Quan’s approval and distribution of the marketing materials.

The SEC sought injunctive relief, disgorgement, prejudgment interest, and civil penalties against Defendants. The court granted injunctive relief, disgorgement, and prejudgment interest. The court, however, denied the SEC’s request for civil penalties, finding the disgorgement awarded was substantial enough to sufficiently deter future securities laws violations.

In sum, the District Court of Minnesota denied Defendants’ motions for judgment as a matter of law and for a new trial and granted in part the SEC’s motion for remedies.

The primary materials for this case may be found on the DU Corporate Governance website.


Court Rules on Sanctionable Behavior Related to Rule 11 Violations

In Super Pawn Jewelry & Loan, LLC. v. American Environmental Energy, Inc., No. 11-cv-08894, 2014 WL 4435454 (N.D. Ill. Sept. 9, 2014), the court found Super Pawn Jewelry & Loan, LLC (“Plaintiff”) jointly and severally liable for sanctions imposed upon one of its attorneys for violations of Rule 11 of the Federal Rules of Civil Procedure (“FRCP”).

Plaintiff originally filed suit against American Environmental Energy Inc. et al (the “Defendants”) alleging that the Defendants had intentionally and wrongfully failed to issue 1,000,000 shares of American Environmental as a result of a merger. Plaintiff asserted that the failure violated Section 10(b) of the Securities Exchange Act of 1934. The court ultimately dismissed the claim and declined to allow for leave to file a third amended complaint. Thereafter, defendants sought sanctions under Rule 11. 

The Private Securities Litigation Reform Act (“PSLRA”) requires that “in any private action arising under this chapter, upon final adjudication of the action, the court shall include in the record specific findings regarding compliance by each party and each attorney representing any party with each requirement of Rule 11(b) of the FRCP.” A violation of Rule 11(b) occurs when any responsive pleading is filed with a frivolous argument, for an improper purpose, or with a factual contention that lacks evidentiary support. To the extent the court finds a violation, the PSLRA creates a presumption that the opposing party must pay attorney’s fees and other expenses. 15 U.S.C. § 78u-4(c)(3)(A). The presumption may be rebutted upon a finding that imposing sanctions either creates an “unreasonable burden” upon the liable party that would be “unjust” and “failure to award the sanctions would not impose a greater burden on the competing party,” or that the “violation of Rule 11 was de minimis”. 

Defendants asserted that counsel for plaintiff violated Rule 11 by failing to adequately investigate claims before filing, and for filing the same, previously-dismissed claims without making a good faith attempt to plead around deficiencies of the first claims. The court determined that each lawyer was “uniquely situated” and analyzed the behavior of each.      

The initial lawyer involved in the case filed briefs in opposition to the Defendant’s motion to dismiss the first amended complaint, but his representation of Plaintiff lasted for only five weeks. As required by the PSLRA, the court assessed the pleading for any potential violation of Rule 11 to determine if sanctions were appropriate. The court found that because the lawyer filed the pleading based on his own belief of the facts, his behavior was not frivolous or sanctionable pursuant to Rule 11(b).

The court considered the actions of the second and third lawyers involved in the case. One asserted that “he played no substantive role in the case, merely serving as local counsel”. Although dismissing the defense, the court found that the record did not establish a failure to engage in a sufficient pre-filing investigation.  

Lastly, the court considered the behavior of Plaintiff’s final attorney. The lawyer filed the second amended complaint. The court found that the complaint “does include some changes, but most (and arguably all) of the fatal deficiencies of the first amended complaint are there.” The complaint reflected a “complete disregard for the Court's ruling on its securities fraud claims.” As the court reasoned:

  • The Court's careful analysis of the first amended complaint, the Court's ruling on Defendants' motions to dismiss it, and the SAC that Plaintiff filed two months later — in the context of the long and troubling history of this case and in light of [counsel’s] own admissions in his brief — regrettably lead the Court to conclude that [counsel] offended Rule 11 in at least one, if not three, of the ways listed above. 

Plaintiff sought to avoid the sanctions imposed under Rule 11.  The court, however, disagreed. 

  • Common sense forecloses Plaintiff's attempt to completely distance itself from its own lawsuit. Benjamin entered an appearance, of course, on Plaintiff's behalf, and — it can reasonably be inferred from timing alone — for the purpose of reviving its dismissed claims. In fact, in Benjamin's opposition brief, he makes clear that, upon returning to the case, he relied on his client's representations in filing the SAC. Plaintiff knew that the Court had just dismissed its claims, and, by authorizing its new attorney to refile them (and/or by hiring him to do so), Plaintiff subjected itself to certain ethical obligations — namely, to permit its attorney only to file claims brought for a proper purpose and grounded in fact based on a "reasonable inquiry under the circumstances."

The court, therefore, granted the motion for sanctions in part and directed defendants to submit a request for fees. 

The primary material for this case may be found on the DU Corporate Governance website.


North American Meat Institute Concedes the Battle but not the War

The court battle between the North American Meat Institute et al. and the US Dep’t of Agriculture (discussed here and here) is over.  On February 9, the Institute filed papers in U.S. District Court to drop its lawsuit seeking to block the USDA’s implementation of mandatory country of origin labeling rule (“COOL rules”).

The initial COOL legislation was amended in 2008 to include guidelines for labeling imported fresh fruits, nuts and vegetables. It was amended a second time in 2013 in response to concerns that meat products were being “co-mingled,” wherein animals born outside the United States but shipped to American feedlots for finishing and slaughter might pass with a “Product of the USA” label. New COOL guidelines require specific designations for livestock born outside the United States but shipped to U.S. feedlots prior to slaughter.

NAMI opposed these rules but suffered three losses in their attempt to black them.  The case was initially filed in July 2013 and NAMI had until Monday to either file paperwork to continue their case or drop it. They dropped it.  

For those of us interested in governmental regulation of corporate speech the cessation of the case means a lost opportunity for the courts to clarify what is now muddled doctrine.  At issue in the North American Meat case was whether the COOL rules violated First Amendment rights, an issues which required the court to consider the reach of Zauderer v. Office of Disciplinary Counsel, 471 U.S. 626, 651 (1985), which found that because: 

  • commercial speech warrants protection mainly due to its information-producing function, …… a commercial actor has only a “minimal” First Amendment interest in not providing purely factual information with which the actor does not disagree….. Such mandates do not violate an advertiser’s First Amendment rights, as long as disclosure requirements are reasonably related to the State’s interest in preventing deception of consumers.” 

North American Meat argued that the COOL rules went beyond preventing the deception of consumers and therefore should be tested under the more stringent Central Hudson Gas & Elec. Corp. v. Public Service Comm'n test which states that: 

  • For commercial speech to come within the First Amendment, it at least must concern lawful activity and not be misleading. Next, it must be determined whether the asserted governmental interest to be served by the restriction on commercial speech is substantial. If both inquiries yield positive answers, it must then be decided whether the regulation directly advances the governmental interest asserted, and whether it is not more extensive than is necessary to serve that interest. 

The DC District Court of appeals disagreed that Zauderer was limited to disclosures aimed solely at preventing the deception of consumers.  Instead it stated  “[f]inding that Zauderer is best read as applying not only to mandates aimed at curing deception but also to ones for other purposes….., we adopt that reading,….” In a somewhat odd move, it then went on to articulate the governmental interests in the COOL rules, stating that

we can see non-frivolous values advanced by the information. Obviously it enables a consumer to apply patriotic or protectionist criteria in the choice of meat. And it enables one who believes that United States practices and regulation are better at assuring food safety than those of other countries, or indeed the reverse, to act on that premise. 

It therefore upheld the rules.  So where are we?  We know that Zauderer will apply to a “commercial speech mandate that compels firms to disclose purely factual and non-controversial information.”  But must the proponent of the mandate still provide justification in the form of governmental interests underlying the mandate?  How strong must those interests be? 

And what is “purely factual and non-controversial information?”   That critical legal issue is left open after this case and will certainly continue to be hard fought in future cases.  We have already seen it called into question in the conflict minerals battle where opponents of the compelled disclosure argue that the information required by the rule goes far beyond what is factual and non-controversial.  The expansion of Zauderer beyond disclosures aimed at preventing consumer deception makes the delineation of “purely factual and non-controversial” all the more important.  The dropping of American Meat means we will have to wait for more guidance on just what that terms means.

While North American Meat Institute may have ceded this legal battle, the war over the COOL rules is not over.  Last October, the World Trade Organization ruled against the US and the COOL rules in response to a complaint brought by Canada and Mexico arguing that the rules unfairly discriminate against meat imports and give the advantage to domestic meat products.  The US appealed that ruling.  Agriculture Secretary Tom Vilsack has said that the WTO should have the final say on COOL suggesting that if the US loses its appeal, the rules will be re-written despite their validation in the US courts.  Failure to do so could lead to retaliatory action by Canada and Mexico Canada who sought WTO permission to impose more than $2 billion a year in tariffs in response to COOL. A WTO decision is expected to be made public next July.


SEC v. Ferrone: Alleged Misstatements Concerning A Biopharmaceutical Drug

In SEC v. Ferrone, No. 11 C 5223, 2014 BL 287831 (N.D. Ill. Oct. 10, 2014), the United States District Court for the Northern District of Illinois, Eastern Division, granted a motion for summary judgment against defendant Douglas McClain Sr. (“McClain Sr.”) and against Douglas McClain Jr. (“McClain Jr.”) for violations of the federal securities laws.  

According to the allegations, McClain Jr founded Argyll Biotechnologies, LLC (“Argyll”) and McClain Sr was the company’s chief science officer.  In 2006, Argyll acquired the rights to “SF-1019,” a biopharmaceutical drug extracted from goat blood, in 2006. Argyll formed Immunosyn Corporation (“Immunosyn”) and provided the company with a worldwide license to market and sell SF-1019.  Argyll retained a majority of the shares of Immunosyn.  

In December 2006, Argyll filed an Investigational New Drug (“IND”) application with the FDA, which contained a proposal for “Phase I” clinical trials of SF-1019 on human subjects. In March 2007, the FDA placed the IND application on a full clinical hold because of insufficient information to assess risk. Both defendants were allegedly aware of the hold. Immunosyn’s public filing with the SEC for the 2007 fiscal year noted SF-1019 had not been approved for human use or treatment of any particular disease, but failed to mention SF-1019 clinical trials were on full clinical hold. During the period from April 2007 to October 2007, while SF-1019 was on hold, the SEC alleged that defendants sold hundreds of thousands of their Immunosyn shares. 

The SEC asserted that McClain Sr. defrauded investors under the securities laws when he took their money but failed to deliver shares of Immunosyn stock.   McCain Sr., however, argued that the issue of scienter could not be resolved on a motion for summary judgment.  The court, however, found that the explanation given by McClain Sr. as to the reasons for not delivering the shares did “not provide a basis upon which a reasonable trier of fact could find that McClain Sr. did not intend to deceive investors at the Texas clinic.”  

The SEC also alleged that McClain Sr. made materially false or misleading statements during a presentation at a Texas clinic and in a video presentation on Immunosyn’s website. The court analyzed this theory by determining whether McClain Sr.’s statements were (1) false or misleading; (2) material; and (3) intended to deceive investors. 

During his presentation at the Texas clinic, the court found McClain Sr. made misleading statements about the FDA approval process and the alleged sale of SF-1019 to the Department of Defense. It also found, any reasonable investor would have viewed these statements as altering the total mix of information about Immunosyn’s primary asset. See Id.  (“Any reasonable trier of fact would conclude that McClain Sr. made false or misleading statements about SF-1019 at the Texas clinic and in his video presentation.”).  The court also found that the alleged misstatements were material and made with scienter.  

The final theory of liability alleged by the SEC was that McClain Sr. and McCain Jr. engaged in insider trading when they sold their Immunosyn stock while in possession of  material, non-public information. The court found that the holds placed by the FDA constituted material non-public information.  The only “contested” issue was whether the Defendants acted with scienter.  As the court noted, “[w]hat remains missing is a legitimate, nonfraudulent explanation of why they sold their Immuosyn shares when they did.”  As a result, “the McClains have failed to rebut the inference that inside information about the FDA holds played a causal role in their sales of Immunosyn stock.” 

Therefore, the court granted summary judgment for the SEC on all its claims. 

The primary materials for this case can be found on the DU Corporate Governance website


Loos v. Immersion Corp: Court Grants Motion to Dismiss in Favor of Defendants

In Loos v. Immersion Corporation, et al, Docket No. 12-15100 2014 WL 4454992 (9th Cir. Aug 7, 2014), the United States Court of Appeals for the Ninth Circuit granted Immersion Corporation’s (“Immersion”) motion to dismiss for failure to state a claim and dismissed John Loos’ (“Plaintiff”) amended complaint with prejudice for failing to sufficiently allege loss causation.

The complaint alleged Immersion engaged in securities fraud under Sections 10(b), 20(a), and 20A of the Exchange Act and Rule 10b-5. According to the allegations, Immersion disclosed in July 2009 “potential problems” with revenues from earlier periods and announced the commencement of an investigation. A month later, the company revealed to investors that previous financial statements were not reliable. The company disclosed the results of the investigation in February 2010 in an annual report on Form 10-K. The investigation uncovered errors in revenue recognition resulting in premature recognition causing earnings to be restated from 2006 through 1Q09. The investigation  did not find any fraudulent conduct. 

The district court granted Immersion’s motion to dismiss for failure to state a claim, finding insufficient allegations of scienter or loss causation.  An amended complaint likewise lacked the same elements. Consequently, the district court granted Immersion’s motion to dismiss and dismissed the amended complaint with prejudice. Plaintiff then appealed to the Ninth Circuit.

To show financial injury resulting from a company’s violation of Section 10(b) and Rule 10b-5, a complainant must establish six elements: (1) a material misrepresentation or omission; (2) scienter; (3) a connection between the misrepresentation and the purchase or sale of a security; (4) reliance upon the misrepresentation; (5) economic loss; and (6) loss causation. To prove loss causation, a plaintiff must allege the economic loss suffered by a decline in market price was a result of the market learning and reacting to fraud specifically, rather than to reports of the company’s poor financial health generally.

The element of loss causation requires plaintiffs to show that the defendant’s conduct was a “substantial cause” of their economic loss. Id. (“Broadly speaking, loss causation refers to the causal relationship between a material misrepresentation and the economic loss suffered by an investor.”).  During the pleading stage, this requires the plaintiff to allege that his or her  stock losses were proximately caused by fraudulent activity rather than changing market conditions, investor expectations or other unrelated factors.

Plaintiff alleged that Immersion systematically posted incorrect revenues.  The market learned of truth through “a series of ‘partial disclosures’ consisting of (1) disappointing earnings results for 1Q08, 2Q08, 4Q08 and 1Q09; and (2) the subsequent announcement of an internal investigation into prior revenue transactions.”  With respect to the earnings disclosure, the court found that the statements were not accompanied by “any information from which revenue accounting fraud might reasonably be inferred.” Nor did the disclosure of the investigation meet the standards for causation.  

The announcement of an investigation does not "reveal" fraudulent practices to the market. Indeed, at the moment an investigation is announced, the market cannot possibly know what the investigation will ultimately reveal. While the disclosure of an investigation is certainly an ominous event, it simply puts investors on notice of a potential future disclosure of fraudulent conduct. Consequently, any decline in a corporation's share price following the announcement of an investigation can only be attributed to market speculation about whether fraud has occurred. This type of speculation cannot form the basis of a viable loss causation theory.

Because Plaintiff’s amended complaint failed to establish loss causation, the Ninth Circuit Court of Appeals affirmed the district court’s decision, granting Immersion’s 12(b)(6) motion to dismiss.

The primary materials for this case may be found on the DU Corporate Governance website.


CDO’s Comprised of Small-Bank Securities Exempted from Volcker Rule

Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), commonly called the Volcker rule, prohibited banking entities from engaging in proprietary trading, or acquiring, retaining, or sponsoring any equity, partnership, or other ownership interest in a hedge fund or a private equity fund. Drafted in response to fears stemming from the economic downturn of 2009, the Volcker Rule limited the ability of banks to participate in what was deemed highly risky market activities.  In effect, the rule would require banks to divest themselves of all collateralized debt instruments (“CDOs”), and so when governmental agencies adopted this rule on December 10, 2013, there was some pushback from those in the banking industry.

Smaller banks in particular have expressed opposition to the Volcker rule, as its implementation would most likely force smaller banks to take up to $600 million in losses on CDOs held by about 300 firms. These smaller banks are especially susceptible to losses in the event that they are forced to restructure the money tied up in the CDOs, which could create a rush to liquidate. Governmental agencies gathered in early 2014 to consider the implications of this rule for smaller banks and developed an interim final rule to exempt certain behavior in response to this issue. The interim rule served as the basis for the final rule that has since been implemented. Agency officials have justified the exemption with the need to alleviate unnecessary regulatory burden on smaller banks.

Under this new exemption, banking entities are permitted to retain an interest in or sponsorship of covered funds by banking entities if certain qualifications are met. For certain CDOs to fall within the scope of the rule and to be eligible for retention by banks, they must be backed by trust-preferred securities established before May 19, 2010, and must be obtained by December 10, 2013, the effective date of the final rule. The exemption also requires that the CDOs be tied to securities issued by banks with less than $15 billion in assets, therefore limiting its scope to smaller banks that may be more affected by the Volcker rule.

Creating the exemption may solve some of the issues with the Volcker rule that could plague smaller bank. It is unclear, however, if the exemption has been applied broadly enough. Other financial instruments, like collateralized loan obligations (“CLOs”), create similar issues if banks are forced to sell off all CLO holdings. In upcoming discussions of governmental agencies, critics of this narrow application may be interested to see if these rulemakers react to comments from the banking industry and introduce additional rules that would apply the exemption on a wider basis.



Colorado Crowdfunding 

The ability to complete a crowdfunding offering in Colorado pursuant to the federal intrastate exemption is less defined (and therefore subject to fewer restrictions) than that available in many states.  There have historically been few limited offering registrations in Colorado.  There is no reason, however, why this process cannot be used by a Colorado company with its principal place of business in Colorado intending to use the proceeds in Colorado. 

  • Form RL provides the basis for public disclosure and is subject to review by the Colorado Division of Securities.  Rather than being limited to the $1,000,000 federal crowdfunding exemption (if the implementing rules are approved), Form RL can be used in an intrastate (Rule 147) offering to raise up to $5,000,000.  The minimum investment can be $100.00 or $100,000; ultimately that, and other aspects of the offering, will be resolved in discussions between the issuer and the Division of Securities.  
  • Where the proposal is to offer $1,000,000 or less and use the federal Rule 504 exemption, the Colorado limited offering registration on Form RL will still be required if the issuer desires to use general solicitation or advertising in Colorado for the offer and sale of the securities. 
  • Where the issuer intends to make the offer through a third party, broker-dealer registration and the licensing of sales representatives under Colorado law also has to be considered.

The rules published by the Colorado Division of Securities have not been updated to contemplate crowdfunding, and therefore there are no restrictions on the minimum size of investment, the number or sophistication of investors, any “bad actor” limitations, or broker-dealer requirements (other than as generally applicable, described in the August 2014 newsletter).  Any offering using Form RL will be subject to review by the Colorado Division of Securities and may be limited by ad hoc limitations imposed by the examiner during that review process. 

Crowdfunding Under Rule 147 – the C&DI’s 

The SEC has a number of Compliance and Disclosure Interpretations (“C&DIs”) discussing SEC Rule 147 and the ability to use general solicitation or advertising.  C&DI 141.03 (April 10, 2014) notes that Rule 147 does not prohibit general solicitation or advertising, but notes that any such advertising or solicitation must be conducted in a manner consistent with the limitations of 1933 Act § 3(a)(11) and SEC Rule 147.  These include a number of requirements that tie the offering, the issuer, its business, and the use of proceeds to a single state. 

Question 141.04 (April 10, 2014) addresses the use of a third-party Internet portal “to promote an offering to residents of a single state in accordance with a state statute or regulation intended to enable securities crowdfunding within that state.  With some limitations (such as disclaimers and limitation of access), the C&DI responds (using a double negative) that “[u]se of the Internet would not be incompatible with a claim of exemption under Rule 147.” 

On October 2, 2014 the SEC issued C&DI 141.05, the SEC addressed the question: “[c]an an issuer use its own website or social media presence to offer securities in a manner consistent with Rule 147.”  In response, the SEC noted that generally these sites are widely available “in a broad and open manner” to customers and the public in general.  The SEC raised the concern that using such a site for the “offer” of securities “would likely involve offers to residents outside of the particular state in which the issuer did business.” 

The SEC then went on to discuss certain measures that the issuer could use “to limit communications that are offers only to those persons whose Internet Protocol, or IP, address originates from a particular state or territory.”  This would (in the SEC’s judgment) prevent offers from being made to persons whose IP address originates outside of the targeted state.  The SEC went on to suggest that “[o]ffers should include disclaimers and restrictive legends making it clear that the offering is limited to residents of the relevant state under applicable law” (in addition to compliance with the other limitations of Rule 147). 

Given the ability of computer users to mask IP addresses, this is likely an unavailable solution.  Of course, setting up a separate site on an issuer’s web accessible only to persons answering questionnaires and otherwise providing qualifying information (as contemplated in C&DI 141.04 and prior no action letters as long ago as Angel Capital Electronic Network (1996 WL 636094 (No Act. 10/25/1996)) and IPONet (1996 WL 431821 (No Act. 7-26-1996))) may satisfy the requirements.  


The Rule 147 intrastate exemption from registration of securities transactions under the federal Securities Act of 1933 remains a viable alternative where companies seek to have a federal exemption for intrastate public offerings while the federal crowdfunding exemption is languishing at the SEC.  

When the SEC rules are finally approved, the federal crowdfunding exemption will pre-empt state law and companies using that exemption will be able to offer crowdfunding securities across state lines following the guidance to be contained in the federal rules.  Until then, intrastate crowdfunding is available in a number of states, and Colorado, through its limited offering registration with Form RL, is one.




When the United States Congress adopted Title III (“Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act” or “CROWDFUND”) of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act,” (Pub. L. No. 112-106), Congress added § 4(a)(6) and § 4A to the Securities Act of 1933 to implement crowdfunding.  Congress also mandated that “[n]ot later than 270 days after the date of enactment of this Act [April 5, 2012], the Securities and Exchange Commission shall issue such rules as the Commission determines may be necessary or appropriate for the protection of investors to carry out section[] 4[(a)](6) and section 4A.”

The 270 days have long-since passed and the rules are languishing at the Commission.  While the federal rules implementing Title III of the JOBS Act do not appear to be proceeding very quickly through the SEC’s rulemaking process, many states are jumping on the crowdfunding bandwagon. is a public site that is following the enactment of crowdfunding regulation throughout the states. 

As of October 2014, these states include Alabama, Colorado, Georgia, Idaho, Indiana, Kansas, Maine, Maryland, Michigan, Tennessee, Texas, Washington, and Wisconsin. has prepared a chart entitled Summary of Enacted Intrastate Crowdfunding Exemptions which discusses state laws permitting crowdfunding (although as of February 3, 2015, the chart does not identify Texas which enacted rules that became effective October 22, 2014 for intrastate crowdfunding).

The crowdfunding exemptions vary among the states. As a general matter, however, a permitted issuer may raise up to $1 million, or in some cases where an issuer has audited financial statements, up to $2 million, in a 12-month period. Certain “bad actor” issuer disqualifications may apply. The exemption is generally available only for equity offerings.  Individual investment amounts are capped to an amount certain; $5,000 and $10,000 caps being most common.  There are simplified disclosure requirements. 

There is a filing requirement, although most intrastate crowdfunding exemptions do not require issuers to provide audited financial statements or any mandatory financial statements unless an issuer is raising more than $1 million. The offering may be required to be made using registered dealer or a qualifying “crowdfunding portal.” An escrow requirement is common, and a declaration or order by the administrator that the offering is exempt may be required. There are in some states post-offering disclosure requirements.


Forum Selection Bylaws and a Race to the Bottom

Delaware has approved the use of forum selection bylaws.  Under these bylaws, shareholders are obligated to bring actions in a designated forum, usually Delaware.  The bylaws typically apply to cases with a nexus to the internal affairs of the corporation.  They apply to actions for breach of fiduciary duty but do not, for example, typically apply to federal causes of action.  So the bylaws do not apply to actions under the federal securities laws.

The forum selection bylaws applied mostly to actions that implicated the internal affairs doctrine. Nonetheless, the bylaws went beyond traditional norms by regulating judicial process.   Judicial process is not a matter of a corporation's internal affairs.  As a result, the issue is not limited to the state of incorporation.  Other jurisdictions can also regulate judicial process, including the venue for particular actions.  The result has been the possibility that corporations will be subject to conflicting requirements.   

The Virginia House has stepped into the fray by specifically approving forum selection bylaws.  The House has adopted an amendment to §13.1-624 to allow bylaws to contain:   

  • A requirement that a circuit court or a federal district court in the Commonwealth or the jurisdiction in which the corporation has its principal office shall be the sole and exclusive forum for (i) any derivative action brought on behalf of the corporation; (ii) any action for breach of duty to the corporation or the corporation's shareholders by any current or former officer or director of the corporation; or (iii) any action against the corporation or any current or former officer or director of the corporation arising pursuant to this chapter or the corporation's articles of incorporation or bylaws.

The requirement is not yet law.  To the extent put in place, it will have limited reach.  The provision only applies to companies incorporated in the state of Virginia.  Moreover, the limit to the Commonwealth or the principal office is largely redundant since businesses incorporated in Virginia are probably headquartered there.

The most interesting aspect of the provision, however, is that it would preclude Delaware as a choice of venue. Few public companies are actually headquartered in Delaware (DuPont is an exception).  Thus, while the provision is unlikely to have significant impact, it is a reflection of another state attempting to eliminate Delaware as a choice of venue.